India Strategy Report

Edelweiss Investment ResearchINDIA STRATEGY: MACRO HEADWINDS AMIDST EARNINGS RECOVERY Sahil Kapoor Shobana Krishnan May 2018 Chief Market Strategist Economist [email protected] [email protected]

OverviewWhere are we in the Cycle?● Stock Markets, Earnings and Economic Cycles all have their own respective Cycles. Stock Market Cycles precedes earnings. Earnings Precedes economic cycles.● Evidences from Global and Indian MarketsIndian Markets● Our Economic cycle suggests we are in the beginning of an economic recovery.● High Frequency Indicators too suggest a nascent recovery is gaining more ground● However signals from- a) Bond Markets (Rising Yields) and Currency Markets b) Valuations-P/E, P/B c) Relationship between global and Indian Markets d) Cyclical versus Defensives Ratio● Indicate thick headwinds for Indian markets in the short term.● If global economic recovery is aging what will drive Indian markets?Global Markets● Are the global markets in the late end of a mature cycle?● Signals from- a. Bond Markets ( Flattening of yields at low interest rates) b. Bond, Commodities and Stock Markets all are Rising c. Valuations- P/E, P/B d. EM currencies outpacing Dollar● So has the global market already peaked in January? 2

Headwinds Ahead, But Earnings SupportiveThe cyclical nature of the economy and stock markets works in varying degrees in each economy. Even after a wellentrenched trend of global trade and globalization the economic cycle of nation states still remain isolated. Globaleconomic strength and weakness accentuates or depresses these cycles.● US appears to be in an aging economic cycle. While almost every economic data set appears robust the age of economic expansion, behavior of the bond market and a few leading indicators suggest that the pace of economic expansion may slowdown.● India seems to be still in a recovery mode. In the last few months economic data like manufacturing, vehicle sales and investments seems to be strengthening the recovery is till patchy.● A thick headwind is present for Indian economy which is likely to keep the recent economic recovery under check.  Trade and fiscal positions for India was improving for India over the last 3 years. It has now begun to deteriorate. Although not alarming but its effect are visible in weakening Indian Rupee and higher borrowing costs.  Strong foreign flows have been a bedrock of each phase of strong economic and stock market cycle in India. These flows have either come in the form of FDI or FPI equity or FPI debt in each of the previous cycle. These flows appear to have tapered and may continue to remain shallow in the short term.  Approaching elections, elevated bond yields, EM currency weakness and deteriorating current account is likely to keep Indian markets under check. But support from earnings in FY19 will be supportive.  Nifty (CMP 10,900) FY18 EPS is likely to see a growth of 8% and close at INR 485. An earning growth of nearly 15% in FY19 would take Nifty EPS to 560. Near term stress may reappear on stock indices and sectors due to macro headwinds. 2018 could remain a year of earnings recovery but PE de-rating.  At 17.5X Nifty is likely to trade near the 10,000 level in the short term and as we approach FY19 end. The markets are likely to trade near 11,500 based on 17.5X FY20 EPS of 660 by June’19 3

India’s Business Cycle Still Weak But Recovering 4

% y-o-yIndia’s Business Cycle: In Recovery Mode, But Still Under Water India’s Seasonally Adjusted Cyclical GDP* 3.8 1.8 -0.2 -2.2 -4.2 -6.2 q1 1997 q3 1997 q1 1998 q3 1998 q1 1999 q3 1999 q1 2000 q3 2000 q1 2001 q3 2001 q1 2002 q3 2002 q1 2003 q3 2003 q1 2004 q3 2004 q1 2005 q3 2005 q1 2006 q3 2006 q1 2007 q3 2007 q1 2008 q3 2008 q1 2009 q3 2009 q1 2010 q3 2010 q1 2011 q3 2011 q1 2012 q3 2012 q1 2013 q3 2013 q1 2014 q3 2014 q1 2015 q3 2015 q1 2016 q3 2016 q1 2017 q3 2017 Source: CMIE, Edelweiss investment Research● From 1997, there have been 4 episodes of Recession (adjusted), longest being from Q1 2000 to Q2 2002 (5 quarters) followed by longest period of expansion from Q3 2003 to Q3 2007 ( 17 quarters).● The last cycle of recession started from Q2 2016 till Q2 2017. We are still in early stages of economic recovery.*Seasonally adjusted series using ARIMA-12,HP Filter and NBER dating algorithm using the spliced Real GDP series available in CMIE. Refer to annexure for cycles interpretation 5

India Remains A Compelling Story As Peers Struggle 6

India: One Of the Major Contributor To World Growth India and China to Contribute 45% of World’s Growth in 2018 0.6 Advanced 3.9 Economies to add only 0.4 25% to World Growth 1.1 Other Emerging Economies to contribute another 25% 0.61.2 About 45% of World Growth to come from India and ChinaChina India Emerging Ex China, india US Advanced Ex US World Source: IMF WEO Database, Edelweiss investment Research● World Output is expected to grow at 3.9% (y-o-y) in 2018, strongest growth projection since 2011.● Advanced Economies were growing rapidly since 2014, while Ems were struggling. The phase of strong EMs growth is expected to return, with EMs contributing 75% to World Growth.China and India are the most influential contributor to World’s Output growth, reiterating that India’s economic 7recovery is gaining traction and remains a compelling long term story

Emerging Market Scorecard: India Less Vulnerable, For Now South Thailand Turkey* Taiwan* South Mexico India Saudi Indonesia Argentina China Brazil Russia Africa* Korea* ArabiaProtectionism Vulnerability 25.6% 51.9% 18.5% 54.8% 36.5% 35.6% 11.3% 32.2% 16.6% 9.1% 19.0% 10.6% 23.3%(Exports as % of GDP, 2017) Rates Vulnerability -2.3% 10.8% -4.6% 13.5% 5.6% -1.8% -1.2% -2.5% -1.5% -3.6% 1.3% -0.7% 2.2%(Current Account Balance as % of GDP, 2017) Oil Vulnerability -3.0% -3.5% -1.6% -3.1% -3.1 0.9% -2.6% 20.9% -1.3% -0.2% -1.2% -0.4% 10.0%(Estimated Net Oil Production as % of GDP, 2016)Vulnerability Ranking(1= Most Vulnerable) 1 2 3 3 5 6 7 8 9 10 11 12 13 Source: Bloomberg Economics, BP Statistical Review of World Energy, International Monetary Fund, World Bank; *Only oil consumption data is available for these economies 8

India’s Macro Stable Compared To 2013, But Deteriorating Thailand 1.0 0.0General Government Balance (% GDP) Indonesia -1.0 China Thailand Brazil Indonesia China 8.0 10.0 12.0 -2.0 -3.0 -4.0 South Africa South Africa -5.0 India India -6.0 -7.0 -8.0 Brazil -9.0 -8.0 -6.0 -4.0 -2.0 0.0 2.0 4.0 6.0 Current Account (% GDP) 2013 2018● India has been following the path of fiscal consolidation, not withstanding slippage in last year.● Among the EMs, Brazil and China have witnessed deterioration both in terms of Current Account and Fiscal Balance. Thailand has improved the most followed by India and South Africa.India’s Current Account Balance and Fiscal Balance shows improvement as in comparison to the times of taper tantrum. Butthis improvement is coming under stress and EM environment become challenging 9

Economy Recovering But Headwinds Ahead 10

Industrial Activity Slowly Gathers Pace, But Still PatchyIndustrial Production Recovers After a Lull Also Reflected in CV and 2 wheeler Domestic Sales Contributions of Sectors to IIP Growth 20 9.0 15 8.0 7.0 12 6.0 5.0 78 7 4.0 3.0 34 2.0 1.0 0.0-1.03MMA y-o-y -3 % y-o-yJan-16 -20 FY15 FY16 FY17 FY18 Feb-16 FY14 Mar-16 Apr-16 CV Sales 2 wheeler Sales May-16 Jun-16 Jul-16 Aug-16 Sep-16 Oct-16 Nov-16 Dec-16 Jan-17 Feb-17 Mar-17 Apr-17 May-17 Jun-17 Jul-17 Aug-17 Sep-17 Oct-17 Nov-17 Dec-17 Jan-18 Feb-18Mining & quarrying Manufacturing Electricity IIP Source: CMIE, Edelweiss investment Research● Industrial production growth has been bolstered by both base effects and recovery in manufacturing especially in industries like chemicals, steel, cement.● Rural Consumption also recovered as indicated by 2 wheeler sales so did commercial vehicle sales.After a considerable slack post Demonetisation and GST, Industrial activity has slowly gathered pace 11

Tentative Signs Of Rural Revival And Credit Growth Rural India Sees Some Recovery, Wages Still Flat Credit Growth at approx. 20%, Industry Credit Sees Positive Growth35% 35%30% 30% 25.025% 25% 20.020% 20% 15.015% 15% 10.010% 10% 5% 5.0 5% 0% 0.0 0% -5% -5.0 -5% -10% -10.0-10% -15%-15% -20% Industry Personal loans Total-20% Source: CMIE, Edelweiss investment Research (%) FY06 FY07 FY08 FY09 FY10 FY11 FY12 FY13 FY14 FY15 FY16 FY17 FY18 Jan-17 Feb-17 Mar-17 Apr-17 May-17 Jun-17 Jul-17 Aug-17 Sep-17 Oct-17 Nov-17 Dec-17 Jan-18 Feb-18 Mar-18 Domestic Tractor Sales (% y-o-y)-RHS Real Rural Wage (%y-o-y)-LHS● Rural revival is becoming likely. Tractor sales indicate improvement in rural economic scenario● Credit to Industry which was in negative zone has been positive since December. Though the gap between retail loan growth and industry loan growth is wide. On a cumulative basis these has been an improvementExpectations of normal monsoon for third consecutive year and increasing capacity utilization have drivenexpectations for both rural and industrial activity. 12

But Deteriorating Macros Creating Pressure On Rupee Widening CAD, Fiscal Slippage and Higher Inflation= Free Fall in Rupee12.0 70.010.0 ? 8.0 65.0 6.0 4.0 60.0 2.0 0.0% 55.0 USD/INR50.0 FY13 Rupee Depreciated by 20% 45.0 40.0 FY14 FY15 FY16 FY17 FY18 FY19E CAD (%GDP) FD(% GDP) Inflation USD INR-RHS Source: CMIE, Bloomberg, Edelweiss investment Research● Rule of thumb says- Every 10 dollar increase in oil prices, widens current account deficit by $9-$10 billion and raises inflation by 0.5 percentage points.Rupee has been under pressure and the pace of deterioration has been quite rapid. Though off from 2013 levels, stillthe worsening will have negative implications. 13

Also Reflecting In FPI Outflows FII Inflows For Equity And Debt Are Absent In 2018 FII Equity Flows have been waning 90 77 90 80 72 80 70 70 60 60 60 50 50 40 56 34 54 40 30 30 20 46 21 49 20 10 3 37 40 24 39 41 3 10 02 0 0 102$ Billion -10-10 $ Billion 23 16 23 27 10 7 28 27 43 46 32 10 13 14 14 2 33 1 29 25 23 12 4 19 3 18 -51 8 7 13 1 20 16 8 9 11 8 3 -1 9 -1 -13 -8-20 -20 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 FII Equity FII Debt FDI Total Source: CMIE, Bloomberg, Edelweiss investment Research● Foreign flows have been tepid lately. In the last two months FPI’s have been net seller in equity and debt markets to the tune of $1.5bn and $3.2 bn respectively.● FDI flows have also seen some decline as emerging markets flows have tapered. Large repatriation into the united states is likely to keep FDI flows into EM slow.Strong foreign flows have supported Indian economy significantly. Debt flows in 2017 kept Indian rates under check. Theabsence of flows may lead to readjustment through currency weakness and elevated yields. 14

Exports Growth: India’s Missed The Global Trade Revival India's Export Growth Moves in Tandem With World, Rising Oil Prices May Lead Inflation As Core CPI Remains elevated Except in 2017 30 India’s high export 25 8.5 75.0 25 growth phase 8.0 70.0 20 7.5 65.0Volume Growth % y-o-y 15 7 % y-o-y7.0 60.0 10 $ per barrel6.555.0 5 6.0 50.0 5 -7 5.5 45.0 0 5.0 40.0 -5 2016 4.5 35.0 -10 4.0 30.0 -15 3.5 2000 2002 2004 2006 2008 2010 2012 2014 Jan-15 Apr-15 Calendar year Jul-15 Oct-15 Jan-16 Apr-16 Jul-16 Oct-16 Jan-17 Apr-17 Jul-17 Oct-17 Jan-18 Apr-18 World EM India Core CPI WTI Crude Oil Source: IMF WEO Database, Edelweiss investment Research● India’s participation in world exports growth between 2003-08 was significant, which is not the case now.● EMs and World Exports have almost doubled from 2016 to 2017, however India’s exports growth actually declined. Low competitiveness and GST led disruptions are two primary reasons for exports growth.Depreciating Rupee could aid exports growth. But to gain significant traction, focussing on export favourablepolicies and establishing trade partnerships with leading world importers are key. 15

Widening Trade Deficit Is A Drag Non oil Exports Growth has remained flat Engineering+ Chemicals+ Electronics account for 51% of imports 5 Year CAGR Growth 400.030%25% 350.0 1.2x 300.0 1.1x20% 250.0 USD Billion 200.0 2.7x15%10% 150.05% 100.0 2.7x0% 50.0-5% 0.0 2003-08 2009-2013 2014-2017 2018 FY05 FY06 FY07 FY08 FY09 FY10 FY11 FY12 FY13 FY14 FY15 FY16 FY17 FY18 1999-02 Non-oil Exports Growth Non-oil Imports Growth Agri Minerals Labour- Intensive Capital -Intensive Other Mfg Other Commodities Non-POL- Total Labour intensive includes Textiles, Leather and Readymade, Capital Intensive includes Engineering, Chemicals and Electronics Source: CMIE, Edelweiss investment Research● Non-oil Exports have remained flat as against growth in Non-POL imports● Engineering, Electronics and Chemicals now account for 51% of imports. Even in 2018, the imports of these items drove the imports. Higher Non-oil imports are also reflective of distress in domestic MSME manufacturing sector due to GST, trailing effects of DeMo and tighter credit conditions.As industrial activity picks up, industrial demand may widen the gap between non-oil imports and exports as seen during2005-08 16

Fiscal Constraints - GST Collections GST FY19 Is Budgeted To BE 23% Higher Than March GST Collections Higher Due To FY Apr-Mar Collections Ending1200 1200.0 30.0% 27.9% 4.5 4.0 1123 3.5 3.01100 1100.0 25.0% 23.1% 2.5 2.0 23% rise 1035 22.0% 1.5 1.0 20.0% 19.7% 0.5 0.01000 1000.0 17.8% 936 930 951900 889 880 893 900.0 15.0% 859 837 10.0% 9.3%800 800.0 7.0% 6.6% 7.1% 7.3% 5.0%700 700.0600 600.0 0.0% Jul-17 Aug-17 Sep-17 Oct-17 Nov-17 Dec-17 Jan-18 Feb-18 Mar-18 FY19B FY14 FY15 FY16 FY17 FY18 GST INR Bn / Month Avg Jul-Mar Apr-Feb Avg March March Over Apr-Feb Avg (RHS)● FY19 budget estimates remain aggressive for GST collections. E-way bill implementation and better compliance is likely to improve GST collections but INR1.12 trn monthly collection appears aggressive until actual numbers flow in.● Central govt tax collections in March were higher than Apr-Feb avg by nearly 2.5 times. GST has smoothed out this effect partly and further smoothening will happen in FY19. March GST numbers may not reflect a trend of higher GST. March to May cumulative data would give first insights on whether the pace of GST collections have picked up. 17

RBI’s Wavering Communication RBI’s Surprises Continue To Confuse Bond Markets 9 Out of policy 50 bps Change of stance from 8.5 cut accommodative to neutral More than expected hawkish 8 minutes, Strong FPI Debt Infows, low inflation 7.5% 7 Cut in inflation forecasts 6.5 Surprised markets by not 6 announcing cuts 5.5 Apr-14 Jul-14 Oct-14 Jan-15 Apr-15 Jul-15 Oct-15 Jan-16 Apr-16 Jul-16 Oct-16 Jan-17 Apr-17 Jul-17 Oct-17 Jan-18 Apr-18 Jan-14 Repo Rate Bond Yields Source: RBI, Bloomberg, Edelweiss investment Research● Fed Governor Ben Bernanke started using Central bank’s forward guidance as a monetary policy tool to prepare the markets. Over a period of time, communication has gained more prominence than actual action.● Of the 91 central banks , 74 central banks across the world use forward guidance as monetary policy tool.RBI has been giving mixed signals about its future rate path by cutting inflation forecasts by 0.5 basis points on one hand andreleasing hawkish minutes later. Moreover, RBI has been switching between headline and core inflation in its commentary. 18

Also, RBI’s Impossible Trinity Makes Matter Worse What should RBI target- Inflation, Rupee or Yield? Foreign Currency InterventionInflation Targeting RBI’s job to keep borrowing cost low for the Debt Management government and continue with inflation targeting is a daunting task Source: Edelweiss investment Research● RBI has recently announced buying back of $1.5 billion bonds. This seems counterintuitive to RBI’s recent hawkish comments and may add to woes of an already depreciating Rupee. With both higher yield and depreciating Rupee can RBI sustain with no action on rates? 19

So Amidst Signs Of Recovery, There Are HeadwindsThere are visible signs of recovery in rural economy and indications of pick up in investments. However there are significant headwindswhich may blunt the reviving part of the economy.● Worsening trade deficit driven by both Oil and non-oil imports appears to be sticky. Exports growth has disappointed till now although it may gain some support from a weaker Rupee● Rising oil prices which are coupled with a weakness in Rupee would push the inflation trajectory higher. This is likely to keep bond yield elevated.● Fiscal deficit for FY19 has been pegged at 3.3% of GDP.  Of the three parts of revenue collections namely direct taxes, indirect taxes and non tax revenue the indirect tax collections are still clouded by GST numbers. GST is budgeted to be nearly 31% of central government overall budgeted expenditure.  The central government has pegged GST collections at INR 7439bn (+26% of FY18E) and at INR 13476bn or a monthly run rate of INR 1123bn (CGST+SGST+IGST) for FY19. This is a 23% jump over the reported average of FY18 GST collections so far. This appears to be challenging under this environment and would keep fiscal conditions under some bit of stress.  Moreover in order to easy financial conditions and bring down bond yields the government has postponed its some of its borrowing to H2FY19 creating substantial uncertainty for the latter part of FY19.● India successfully attracted record levels of FDI flows in 2014 to 2016 period. As US companies repatriate cash due to the one-time tax on undistributed foreign earnings included in the tax reform. FPI flows are expected to slow.● FPI equity flows which were $61bn in 2012 to 2014 have totalled just $16bn from 2015 to 2017. Indian received $23bn of FPI debt flows in 2017 and this pace has also slowed due to declining Rupee and narrowing of yield differential between US and India.● Slowing of FDI and FPI flows would keep financial conditions tighter in India in comparison to easy years of FY15 to FY17. 20

Cues from Global Markets : All Is Not Well 21

Global Economic Recovery Is Aging● The current expansion in US is now 106 months and is the 2nd longest in the post world war world. This old a cycle is not ‘Early’ by any measure. More importantly economy has the support of 1. Exceptionally low levels of interest rates 2. Tax cut led fiscal spending 3. Revival in commodity prices 4. Strong trade growth● For bond markets to reflect poor growth at a time when US Fed has begun quantitative tapering indicates its less optimistic about growth prospects in the near future.● The argument that it is natural for yield curve to invert in the early cycle seems out of place in this phase of the economic cycle. Flattening of US yield curve is indicative of two aspects. 1. The yield curve usually flattens when Fed begins to raise rates initially. However the current Fed rate hike are happening very late in the cycle 2. At such low levels of interest rate, fiscal spending and still a huge level of global quantitative easing the flattening indicates bond markets lack of enthusiasm about growth. Given such record levels of borrowing which is ahead in the next two years the growth needs to be much stronger than it is at present. 22

What Does It Mean For India● For the first time in modern history the US govt has introduced a large counter cyclical fiscal support through the Tax cuts and jobs acts of 2017. This will have the following probable impact 1. The US will run a trillion dollar deficit for the first time after 2011 2. The US treasury is borrowing heavily in the bond market. This is happening at a time when US Fed has begun to taper its balance sheet.● The above two have resulted in higher yield and would continue to keep interest rates elevated at least at the short end. This would lead to softening of price multiples for equities across the globe.● Global growth is showing initial signs of slowing. Most developed countries have had a period of very strong growth in the last two 6 to 8 quarters. Various PMI readings have slowed recently indicating tapering of growth● If economic growth in developed world led by US weakens, the tighter liquidity conditions will be a drag for emerging markets.● India which is facing deterioration in its macros would witness significant headwinds in the short term. It is already reflected partly in rising bond yields and weakening currency.● We expect Rupee to breach its lifetime low against the US Dollar and head towards the 70 level. This would partly readjust the dynamics and help in recovery thereafter. 23

Current Economic Expansion Is AgingRecession Start Date Expansion Start Date Peak US Unemployment Rate Months of Expansion Expansion began after months of recession31-Dec-2007 31-Jul-2009 9.5 10631-Mar-2001 31-Dec-2001 5.7 72 19 31-Jul-1990 30-Apr-1991 6.7 119 9 31-Jul-1981 31-Dec-1982 10.8 91 931-Jan-1980 31-Aug-1980 7.7 11 1731-Dec-1973 30-Apr-1975 8.8 57 731-Jan-1970 31-Dec-1970 6.1 36 1631-May-1960 31-Mar-1961 6.9 106 1130-Sep-1957 31-May-1958 7.4 24 1031-Aug-1953 30-Jun-1954 5.6 39 8 66 10 Avg 119 12 Longest 11 19 Shortest 7● The current expansion in US is now 106 months and is the 2nd longest in the post world war world. This old a cycle is not ‘Early’ by any measure. More importantly economy has the support of a. Exceptionally low levels of interest rates, b. Tax cut led fiscal spending, c. A revival in commodity prices, d. Strong trade growth● For bond markets to reflect poor growth at a time when US Fed has begun quantitative tapering indicates its less optimistic about growth prospects in the near future.● The argument that it is natural for yield curve to invert in the early cycle seems out of place in this phase of the economic cycle. 24

Yield Curve Is Flat 3.0 US Govt 10 Year Yield - US 2 Year Yield 2.5 2.0 1.5 1.0 0.5 0.0-0.5-1.0300025002000150010005000 May-91 May-94 May-97 May-00 May-03 May-06 May-09 May-12 May-15May-88 U.S. Recession S&P 500 Index● Flattening of US yield curve is indicative of two aspects.● Firstly yield curve usually flattens when Fed begins to raise rates initially. However the current Fed rate hike are happening at a time when economic recovery is 106 months old. The 2nd highest consecutive expansion since the second world war.● Secondly at such low levels of interest rate, fiscal spending and still a huge level of global quantitative easing the flattening indicates bond markets lack of enthusiasm about growth. Given such record levels of borrowing which is ahead in the next two years the growth needs to be much stronger than it is at present. 25

US Employment Picture Is As Good As It Gets U.S. Recession US Unemployment Rate 12 per. Mov. Avg. (US Unemployment Rate)12 10.8 10.010 9.08 7.5 7.8 7.0 6.3 6.0 5.66 4.6 5.0 3.9 4.8 3.4 4.44 3.8 3.72 2.50 May-55 May-60 May-65 May-70 May-75 May-80 May-85 May-90 May-95 May-00 May-05 May-10 May-15May-50● US unemployment rate below 4% is rare. There is only one instance of unemployment rate below the 4% mark in the modern era after the global economy was opened under GATT and then WTO.● Interestingly most prior recessions were preceded by unemployment rate moving above its 12 months moving average.● At this juncture there is no such sign but its quite evident that the US economy is witnessing a very robust employment market. This could remain a key monitorable for 2018-19 26

Counter Cycle Fiscal Stimulus : First Of Its Kind U.S. Recession US Treasury Federal Budget (% GDP) US Current Account Balance (% GDP) 4 Tax Cuts and Jobs Act of 2017 2 introduces a sort of fiscal stimulus 0 when economy wasn’t threatened by -2 a recession -4 -6 Fiscal stimulus during recession -8-10 Mar-73 Mar-78 Mar-83 Mar-88 Mar-93 Mar-98 Mar-03 Mar-08 Mar-13 Mar-18-12 Mar-68● For the first time in modern history the US govt has introduced a large counter cyclical fiscal support through the Tax cuts and jobs acts of 2017.● This will have two clear impact – a. the US will run a trillion dollar deficit for the first time after 2011 , b. the US treasury is borrowing heavily in the bond market. This is happening at a time when US Fed has begun to taper its balance sheet.● The above two have resulted in higher yield and would continue to keep interest rates elevated at least at the short end. 27

Liquidity Tap Tightening, Although Slowly Global-Aggregate Bond Total Return Index (LHS) Fed, ECB, BOJ aggregate balance sheet (RHS, USD Trn)500 16490 15480 14470 13460 12450 11440 10430 9 8 Jan-15 Jul-15 Jan-16 Jul-16 Jan-17 Jul-17 Jan-18● Global central bank balance sheet (represented by US FED + EU ECB+ Japan BOJ above) still has support from ECB and BOJ. The US Fed has already begun to unwind its balance sheet.● Add our earlier hypothesis of robust employment growth, higher borrowing by governments and elevated commodity prices the interest rates are set to rise further.● Higher interest rates can lead to readjustment of P/E multiples. This means globally there could be a period of P/E de- rating in 2018. 28

Retail Holding Of Equities Expanding U.S. Recession Equity portion of U.S. household financial assets US CPI50 Dec-52 Dec-57 Dec-62 Dec-67 Dec-72 Dec-77 Dec-82 Dec-87 Dec-92 Dec-97 Dec-02 Dec-07 Dec-12 Dec-174540353025201510 5 0-5Dec-47● Equity markets massive bull run has made sure that the equity portion of US households financial assets is now at the second highest levels after the Dotcom fuelled rally of 90s.● Spurts in inflation and especially recessions where economy becomes overheated results in this ratio cooling off for extended periods. 29

Deceleration In Growth? 65 Global growth is showing initial signs of slowing. Most developed countries have had a period of very strong growth in the last two 6 to 8 quarters Various PMI readings have slowed recently indicating tapering of growth 60555045 May-15 Jun-15 Jul-15 Aug-15 Sep-15 Oct-15 Nov-15 Dec-15 Jan-16 Feb-16 Mar-16 Apr-16 May-16 Jun-16 Jul-16 Aug-16 Sep-16 Oct-16 Nov-16 Dec-16 Jan-17 Feb-17 Mar-17 Apr-17 May-17 Jun-17 Jul-17 Aug-17 Sep-17 Oct-17 Nov-17 Dec-17 Jan-18 Feb-18 Mar-18 Apr-18 U.S. PMI Eurozone PMI EMs Manufacturing PMI India Manufacturing PMI 30

Leading Indicator Showing Some Slack MSCI World Index 12-month EPS estimates YoY South Korea Exports YoY (3MMA)Percentage Chg 50 40 30 Apr-07 Apr-08 Apr-09 Apr-10 Apr-11 Apr-12 Apr-13 Apr-14 Apr-15 Apr-16 Apr-17 Apr-18 20 10 0 -10 -20 -30 -40 -50 Apr-06● Global trade is an important indicator of economic strength. South Korean exports historically have been a good proxy for economic growth trends and even earnings cycles, especially for Ems● South Korean exports have slowed recently indicating that EM EPS growth may slowdown in the short term. 31

Indian Markets: Earnings Recovery Still Nascent, Markets In Mid Cycle 32

Earnings Cycle: Is The Worst Over? But Recovery in Sight, Though Momentum is Slow Earnings Downgrades Continue 26% 20% 22% 11% Nifty EPS versus Consensus Estimates 15% 9%600550 8% 7%500 3%450400 -1%350 Widening of Gap -5%300 between Estimates250 and Actuals -13%200 Mar-08 Mar-09 Mar-10 Mar-11 Mar-12 Mar-13 Mar-14 Mar-15 Mar-16 Mar-17 Mar-18 Mar-19150100 Nifty EPS GrowthJun-06 Source: Bloomberg, Edelweiss investment Research Nov-06 Apr-07 Sep-07 Feb-08 Jul-08 Dec-08 May-09 Oct-09 Mar-10 Aug-10 Jan-11 Jun-11 Nov-11 Apr-12 Sep-12 Feb-13 Jul-13 Dec-13 May-14 Oct-14 Mar-15 Aug-15 Jan-16 Jun-16 Nov-16 Apr-17 Sep-17Trailing 12 month EPS Forecast EPS● Widening of Gap between Forecasted EPS for the quarter and actuals had widened Since 2015 indicating lower than expected earnings season.● Earnings Recovery look in sight, however disruptions like GST delayed the earnings recovery cycle● Earnings growth expectation for FY19 is rather steep, it is yet to be seen whether scenario of FY08, FY11 will repeat or not Momentum though sow, the worst for earnings cycle is likely over 33

Nifty Earnings: Can The Expectations Be Matched? Earnings broadly in line We may see a 2nd consecutive quarter of in line earnings 160 Actual earnings have lagged estimates, but things are changing 140 120 100 80 60 40 20 06 Beat 7 In-Line 13 Missed Nifty Estimates v/s Actual Dec-15 Mar-16 Jun-16 Sep-16 Dec-16 Mar-17 Jun-17 Sep-17 Dec-17 Mar-18 Estimates Actual Source: Bloomberg, Edelweiss investment Research● Among the 26 Nifty companies with reported results, Nifty has reported a PAT growth of 15% v/s estimate of 16%.● Nifty earnings growth has been supported due to earnings beat by heavyweights. Ex of TCS, Reliance and HDFC twins, Nifty earnings has missed estimates by 6% excluding these comapies.● Nifty earnings have been consistently missing estimates since the past 10 quarters. We may see a 2nd consecutive quarter of earnings meeting estimates for the first time in past 10 quarters. Earnings growth supported only by heavyweights, broader recover insight 34

Earnings Recovery To Gain From Inflationary Pressure, Support Equities Corporate Profits, generally leads Nominal GDP Growth 12% WPI Inflation and EPS Generally Tend to Move Together 10%80% 25.0% 50% 8% 40% 60% 20.0% 6% 30% 40% 15.0% 4% 20% 20% 10.0% 2% 10% 5.0% 0% 0% 0% -2% -10%-20% -4% -20% -6% -30% -8% -40%-40% FY00 0.0% FY01 FY02 FY03 FY04 FY05 FY06 FY07 FY08 FY09 FY10 FY11 FY12 FY13 FY14 FY15 FY16 FY17 Mar-02 Oct-02 May-03 Dec-03 Jul-04 Feb-05 Sep-05 Apr-06 Nov-06 Jun-07 Jan-08 Aug-08 Mar-09 Oct-09 May-10 Dec-10 Jul-11 Feb-12 Sep-12 Apr-13 Nov-13 Jun-14 Jan-15 Aug-15 Mar-16 Oct-16 May-17 Dec-17 Corporate Profits Growth Nominal GDP Growth - RHS WPI-Inflation (y-o-y) Trailing 12 Month Sensex EPS (%y-o-y)- RHS Source: CMIE, Bloomberg, Edelweiss investment Research● Earnings Cycle leads the economic recovery cycle.● Controlled inflationary scenario is growth positive as earnings are nominal phenomena. WPI specifically as it indicates producers’ prices.● Supply-Demand mismatch drive prices up. During 2003-08, higher demand led to rise in prices. Though, this time around price rise is more supply led there is no denying that industrial activity is gaining momentum. Gain in WPI is reflective of probable pick up in earnings, going ahead 35

Valuations : Mind The Gap16 Period of Continued Stress 814 Stock Period of Period of Secular Period of in industrial ?7 Market Consolidation Bull Run Consolidation activity12 Boom 610 5 8P/BV 4 6 P/BV 4 3 2 2 0 1 0Jan-92 Oct-92 Jul-93 Apr-94 Jan-95 Oct-95 Jul-96 Apr-97 Jan-98 Oct-98 Jul-99 Apr-00 Jan-01 Oct-01 Jul-02 Apr-03 Jan-04 Oct-04 Jul-05 Apr-06 Jan-07 Oct-07 Jul-08 Apr-09 Jan-10 Oct-10 Jul-11 Apr-12 Jan-13 Oct-13 Jul-14 Apr-15 Jan-16 Oct-16 Jul-17 Apr-18 CMIE Consumer Index CMIE Metals & Metal Products Index-RHS Source: CMIE, Edelweiss investment Research● A pick up in industrial activity or expectations of the same drive valuations for cyclicals stocks . During 2007-08, the valuations for cyclicals peaked before the stress in stock markets were evident.● Consumer Goods, considered as defensives have seen their valuations run up in last couple of years when economic activity was under stress.● Recently, both metals and consumer goods are above their long term and 10 year averages, indicating revival. 36

Cyclicals Have been Performing, Ahead Of Economic Strength Sector RankRank 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 1 TELECOM UTILITIES FMCG METALS AUTO IT BANKS HEALTHCARE METALS REALTY 2 MATERIALS METALS HEALTHCARE AUTO HEALTHCARE FMCG BANKS INDUSTRIALS CONS.Disc MATERIALS CONS.Disc 3 INDUSTRIALS ENERGY TELECOM MATERIALS BANKS HEALTHCARE CONS.Disc ENERGY MATERIALS 4 ENERGY INDUSTRIALS NIFTY FMCG HEALTHCARE REALTY TELECOM AUTO IT UTILITIES ENERGY 5 TELECOM BANKS IT FMCG HEALTHCARE TELECOM AUTO TELECOM 6 NIFTY MATERIALS INDUSTRIALS IT TELECOM FMCG AUTO BSE500 BANKS BANKS 7 IT BSE500 IT CONS.Disc NIFTY NIFTY NIFTY FMCG CONS.Disc METALS 8 BANKS ENERGY BSE500 IT AUTO BSE500 MATERIALS ENERGY BSE500 BSE500 9 BANKS UTILITIES BSE500 CONS.Disc ENERGY UTILITIES FMCG INDUSTRIALS 10 METALS NIFTY BANKS INDUSTRIALS AUTO CONS.Disc CONS.Disc FMCG AUTO NIFTY FMCG 11 BSE500 CONS.Disc AUTO HEALTHCARE MATERIALS BSE500 INDUSTRIALS UTILITIES 12 CONS.Disc BSE500 NIFTY TELECOM CONS.Disc HEALTHCARE INDUSTRIALS IT UTILITIES REALTY NIFTY 13 AUTO FMCG CONS.Disc ENERGY METALS BANKS ENERGY NIFTY AUTO 14 UTILITIES HEALTHCARE INDUSTRIALS UTILITIES ENERGY NIFTY INDUSTRIALS METALS TELECOM INDUSTRIALS IT 15 HEALTHCARE MATERIALS REALTY UTILITIES REALTY BANKS HEALTHCARE IT FMCG AUTO METALS FMCG REALTY BSE500 BSE500 MATERIALS METALS REALTY HEALTHCARE IT REALTY TELECOM UTILITIES MATERIALS TELECOM ENERGY NIFTY REALTY METALS BANKS MATERIALS UTILITIES METALS MATERIALS ENERGY INDUSTRIALS UTILITIES METALS IT REALTY TELECOM CYCLICALS Source: Bloomberg, Edelweiss investment Research DEFENSIVES SENSITIVE● For the last 2 years, cyclicals and sensitive sectors form most of the top 10 performing sector.● This is also another indication, we might be in the mid-phase of the cycle.● Also, broader markets have been performing better than Nifty. 37

Market Breadth Has Been Weak Lately, Indicates Another Possible Correction S&P BSE 500 Index S&P BSE 500 Index members above their 200 DMA16000 10015500Index Level 9015000 % of Index Member above/below 200DMA8014500 7014000 6013500 5013000 40 3012500 20 May-17 Jun-17 Jul-17 Aug-17 Sep-17 Oct-17 Nov-17 Dec-17 Jan-18 Feb-18 Mar-18 Apr-18 Source: Bloomberg, Edelweiss investment Research● Market breadth has been weakening lately. Large cap stocks seems to have an upper hand while the broader market seems to be under pressure.● Weakness in breadth throws out cautious signal for the trend. This indicates that markets may see another phase of correction.● We expect Nifty to face another round of selling towards the March’18 lows 38

But Domestic Liquidity Holding Up The Market DII Equity Holdings Now 70% of FII Equity Mutual Fund SIP Flows are up 52% in FY18 Holdings 80400 350 70 Total INR 439 billion Total INR 671 billion,350 320 60 growth of 52%300 INR Billion 50 250250200 40150 130100 3050 200 FY18 10 FY12 0 DII ($Billion) FII ($Billion) Apr-16 Jun-16 Aug-16 Oct-16 Dec-16 Feb-17 Apr-17 Jun-17 Aug-17 Oct-17 Dec-17 Feb-18 DIIs equity holdings include Insurance Equity AUM and Mutual Fund AUM Source: Bloomberg, Edelweiss investment Research● In spite of the slow earnings momentum and rich valuations, domestic flows have been a solid support to the Indian markets.● Domestic mutual fund SIP flows have now reached $1bn a month. This is a sizeable and supportive number and has been instrumental in keep stock volatility under check.● Domestic flows may not be able to dictate the direction of the market but would continue to keep volatile under check. 39

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Annexure 41

Economic And Stock Market Cycle Economic Cycle 9 Top 3 Stock Market Cycle 6 11 1 8 7 5 Late 10 4 Bull Middle Early Middle 4 Bull Bear Recession 2 Middle Middle Recovery Bear Bottom Early Bull Late Trough Bear1 Consumer 5 Technology 9 Energy Non-Cyclicals 6 Basic Industry 10 Utilities Consumer Cyclicals 7 Capital Goods 11 Precious Metals2 (durable and non) 8 Transportation3 Health Care4 Financials 42

Economic Phases and Market Cycles Broad Characteristics of Market Cycles Early Cycle Mid Cycle Late Cycle StrongEconomic Fundamentals Weak Improving StrongEmployment LowVolatile Weak Improving HighValuations HighSentiment High Improving LowInvestment Potential Low Improving Low Improving Excellent Good 43